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Alternatives

Challenges, and opportunities

Last week’s UK referendum result took much of the market by surprise, as shown by the sharp drop in sterling and the FTSE 250 index over the following two days. We too had been of the view that a Leave vote was relatively unlikely. We had taken some hedging positions on the fund’s short book, but we were net long domestic cyclical sectors going into the vote.

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Mario Draghi rattled fixed-income markets last month when the European Central Bank (ECB) president hinted at the eventual unwinding of the stimulus programme underway in the euro area: bond yields spiked and the euro lurched higher.

On Thursday, after the ECB’s Governing Council meeting, he has a chance to further flesh out those remarks or row back on them.

We believe that a tapering of the central bank’s asset purchases later this year or early next year is highly likely, given the healthy state of the euro area economy. The unemployment rate is falling rapidly, growth is robust – and crucially, as economic slack is eroded, we expect core inflation to rise.

Investors may need to wait a little longer, perhaps until the Governing Council’s meeting in September, for clear guidance as to when the ECB will start this process in earnest. Still, a significant hawkish turn is already priced into the euro rates market, with money-market forwards indicating that the central bank will conduct a series of interest-rates hikes over the coming four years.

Inflation-linked securities tell a different story, however. The one-year, three-year forward euro inflation swap rate points to consumer prices rising at about 1.29% in the monetary bloc in the period between 2020 and 2021. This is significantly less than the ECB’s target inflation rate of below but close to 2%.

In light of the positive economic backdrop, we see significant value in these securities. They still have some way to go to reach the levels seen in comparable US and UK swaps; and because the expectations embedded in them for consumer prices are already very low, a negative inflation shock to the euro area would probably not drag these prices materially lower.

As a hedge against our somewhat rosy view on inflation, we favour longs in the very front-end euro rates that price in a tightening policy of monetary policy over the coming years. These securities may not sell off much further, given the recent move inspired by Draghi’s comments in June – and could rally in the event the outlook does indeed deteriorate.

Such diversifying positions, held in tandem, we believe offer the balance we seek to achieve in our strategy – and should enable us to take a long view of whatever surprises, or lack thereof, Draghi springs on the market.

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